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Summary of "Determinants of Corporate Leasing Policy" by Clifford W. Smith

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Table of Contents

  • Purpose of the paper
  • Introduction
  • Literture review
  • Main findings
  • Conclusion

Purpose of the paper

Current financial literature assumes that operational cash transactions obtained on the ground from leasing or ownership are based on tax incentives for corporate leasing policy. This paper suggests that taxes are important in identifying potential tenants and analysts, but less important in determining the specific assets leased. This paper presents a consolidated analysis of the various incentives that affect the lease decision. Finally, it illustrates how these incentives use contractual legal provisions such as maintenance clauses, deposits, asset purchase options and corporate leasing policy determinants.

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Introduction

When a company purchases a financial asset for another company, it obtains the right to services of that asset during the period that the former company owned, as well as the right to sell the asset at any future date. The right to asset services and for a specified period of the contract. We believe that taxes play an important role in clarifying certain dimensions of the leasing policy, for example, the choice between the manufacturer and leasing from a third party. However, taxes provide only a limited explanation for the reasons for leasing the assets identified rather than their ownership, and for choosing the provisions in the leases. In this paper, we want to achieve two things: (1) provide a uniform analysis of the various incentives that affect the rent-for-purchase decision; and (2) use this analysis to explain the observed change in corporate leasing policy.

Literture review

Generally, an asset's value is affected by its history of use and maintenance. If an asset is owned and used by the same agent, then use and maintenance incentives are internalized-there are direct private incentives to maximize value since the owner/user bears the full cost of abuse. But a lessee does not have the right to an asset's residual value and hence has less incentive to care for the asset. Authors of our paper believe that their analysis also helps explain the results of studies such as Ang/Peterson, which examine trade-offs between leasing and debt. They find that the use of leases and debt are complimentary: firms which issue more debt tend to engage in more leasing.

When we talk about Comparative Advantage in Disposing of the Asset, if the lessor has a comparative advantage in disposing of the asset, this provides an incentive to leas. Three potential sources of this comparative advantage are: (1) the reduction in search, information, and transaction costs associated with the lessor's provision of a centralized marketplace for the asset; (2) the reduction in service costs from reusing components of previously leased machines in the repair and maintenance of current machines; and (3) the reduction in production costs from reusing components of previously leased machines in the manufacture of new machines.

The existing finance literature analyzing corporate leasing policy concentrates on the tax-related incentives to lease or buy. Brealey and Myers note that most non-cancellable leases are net leases. Brealey and Myers argue that if a manufacturer can affect the rate of technological obsolescence, that manufacturer has an incentive to offer to lease. By leasing some of its machines, the manufacturer signals to potential buyers that since it will suffer when obsolescent-leased equipment is returned, it has a reduced incentive to innovate quickly and thereby reduce the value of its current output. The value of this signal should be reflected in higher selling prices for the manufacturer's current generation of products.

About Metering and Price Discrimination, Bursteinin and Liebowitz argue that metering provisions and tie-in sales in leases provide opportunities for price discrimination. If lessees with different use intensities also have different demand elasticities, metering allows the firm to extract more rents. For example, American Can Company only leased their can-closing machines and required lessees to use their tin cans. The Court ruled that this practice was an illegal tying arrangement, and that the refusal to sell their products precluded competition by third-party lessors. Again in Price Discrimination Opportunities, If a manufacturer has a monopoly and thus can control the total supply of a durable asset, his ability to extract price above a marginal cost can still be restricted by customers' expectations. If the monopolist can only sell the asset, he will produce as long as price exceeds marginal cost. But potential customers, forecasting this behavior, have no incentive to pay more than marginal cost. Coase argues that by leasing, the monopolist bears the cost of expanding the supply, and can thus more effectively exploit his monopoly position, but Flath argues similarly that leasing allows a manufacturer/lessor more effectively to bond quality.

Incremental personal tax liabilities should be capitalized into the price of the debt when sold, and thus the net tax advantage of debt is related to the difference in effective marginal tax rates facing the corporation and the marginal individual in the bond market.

About Specialization in Risk-bearing. For certain production processes (generally small and noncomplex operations), the gains from specialization in risk-bearing and management associated with the corporate form of organization are less than the concomitant agency costs caused by the separation of ownership and control. In these circumstances, as Fama and Jensen note, the individual proprietorship is a more efficient form of organization than the corporation. The existing finance literature analyzing corporate leasing policy concentrates on the tax-related incentives to lease or buy. We believe that taxes play an important role in explaining certain dimensions of leasing policy, for example, the choice between manufacturer and third-party leasing. However, taxes provide only a limited explanation of why specific assets are leased rather than owned, and for the choice of provisions in lease contracts.

lein et al note that bilateral monopoly creates incentives to internalize these contracting problems by purchasing assets highly specialized to the firm. For example, we expect to observe corporations leasing office facilities with greater frequency than production or research facilities. Moreover, differential consequences of a production delay lead most newspaper publishers, but few book publishers, to own their presses. Authors of this paper assume that tax rates remain constant over time and income.

McConnell and Schallheim employ a compound option framework to value these options, treating the asset's expected rate of economic depreciation as an exogenous variable.) We expect these options to be used when the asset's terminal value is affected by use or maintenance decisions. Since the value of the option is a positive function of this terminal value, these options reduce the perverse use and maintenance incentives for the lessee.

Research methodology

  1. Tax Determinants of the Lease-Versus-Buy Decision
    • An Irrelevance Proposition

    In Table I of the paper authors categorize the different cash-flow implications of leasing and purchasing.

    • Effective Marginal Tax Rates

    If the lessor and lessee face different effective marginal tax rates, leasing can reduce the total tax bill. The lower panel of Table I sets out the present values of the tax related cash flows from leasing and purchasing.

    • Manufacturer Versus Third-Party Leasing

    For some assets, leases are offered both by manufacturers and by third-party lessors.

    • Allocation of the Investment Tax Credit

    As noted in Table I, if a firm buys an asset, it receives the investment tax credit, but if it leases the asset either the lessor or the lessee can take the investment tax credit.

    • Nontax Determinants of the Lease-Versus-Buy Decision

    Examination of the tax code reveals that there are identifiable tax-related incentives for leasing.

    • User Characteristics Affecting the Leasing Decision

    Authors first examine incentives established through financial contracts, compensation contracts, and ownership structure.

    • Lessor Characteristics Affecting the Leasing Decisions

    Authors next examine two additional nontax incentives for corporate leasing policy. Since these incentives vary both across potential lessors and across assets, they also help identify which assets will be leased.

  2. Provisions in Lease Contracts
    • Bonding Use and Maintenance

    The primary role of these provisions is to bond the lessee to compensate the lessor if the leased asset is either not returned on time or returned in an abused condition.

    • Capital Versus Operating Leases

    For accounting purposes the definitions of operating and capital leases are set out in paragraphs 6 and 7 of the Financial Accounting Standards Board Standard No. 13.

  3. Options
  4. If the term of a non-cancellable (financial) lease could be written to match the expected useful life of the asset, then the problem of undermaintenance and abuse would be largely controlled. While this approach has been disallowed by the Internal Revenue Service (which considers such a contract to be a "constructive sale"), we observe several provisions in leases which appear to be consistent with this principle.

Main findings

Authors 's analysis implies that leasing is more likely in the following cases:

  1. If the value of the asset is less sensitive to use and maintenance decisions.
  2. If the asset is not specialized to the firm.
  3. If the expected period of use is short relative to the useful life of the asset.
  4. If corporate bond contracts contain specific financial policy covenants.
  5. If management compensation contracts contain provisions specifying payoffs as a function of the return on invested capita.
  6. If the firm is closely held so that risk reduction is important.
  7. If the lessor has market power.
  8. If the lessor has a comparative advantage in asset disposal.

Authors also show how these incentives explain the use of standard contractual provisions such as maintenance clauses, deposits, penalty clauses, restrictions on use, options to extend, and metering.

Conclusion

We believe that authors analysis helps explain the results of studies which examine trade-offs between leasing and debt. We can see that authors concluded that the use of leases and debt are complimentary: firms which issue more debt tend to engage in more leasing. Although leasing and debt are substitutes for a given firm, looking across firms, characteristics of firms' investment opportunity sets which provide high debt capacity also tend to provide more profitable leasing opportunities.

Finally, in order to measure the extent of substitutability between leases and debt, the differences in the characteristics of the specific assets used by different firms must be controlled.

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